Basis: The Essential Tax and Investing Term

First, let's start with what "basis" means. Your basis is usually what you paid for an asset. According to the IRS, a capital gain or loss is the difference between your basis and the amount you get when you sell an asset. So, if you sell an asset that is worth more than you paid for it, you will have to pay taxes on the gain.

If for example, you had purchased stock many years ago for $10 a share and you sold it today for $75 a share, the $65-per-share gain would have to be taxed. These capital gains taxes will vary depending on whether they are considered short-term gains (assets held for less than one year and taxed as ordinary income) or long-term gains (assets held for more than one year and taxed at between 0 percent and 23.8 percent, depending on your income level). Basically, for long-term capital gains, the rates are 0 percent, 15 percent or 20 percent, based on income, with an additional 3.8 percent for certain high-earners as part of the Affordable Care Act.

Tax reform passed in late 2017 didn't change the capital gains rates, but bracket adjustments may have changed your situation, so don't assume that your tax obligations may be the same this year.

While capital gains taxes can be significant, the government gives heirs a break when they inherit appreciated stock. When someone inherits an asset, the cost basis of the asset is "stepped up to value" on the date of death.

Let's assume that an elderly parent leaves a home to her grown children. The home was purchased 40 years ago for $50,000 — the original basis — and is valued at $400,000 on the date of death. While the beneficiaries may have to pay estate or inheritance taxes depending on the size of the estate, they will not be responsible for capital gains tax on $350,000 worth of gains if they decide to sell the house. The government immediately resets that $50,000 basis to $400,000.

Since they received a step-up in basis, they will be responsible only for gains that might occur from the point at which they inherit the asset and then sell it. So if the beneficiaries later sell the home for $425,000, only the $25,000 is considered a gain as it represents the increase in value after the original owner passed away. (Also, homes usually get a substantial break from capital gains anyway.)

Now that you know about this, you should examine the cost basis of assets before you think of gifting as the preferred means of transferring wealth.

Estate planning attorneys note that too often an emphasis is made on gift-giving to avoid a modest amount of estate tax, because then the recipient of the gift is confronted with a large capital gain to be paid when selling the gifted item. Holding the property rather than gifting it to the beneficiary could relieve that beneficiary of any capital gains tax if there is no additional gain on the value of the property. It's a good idea to consider this for any highly appreciated property, as gifting could result in capital gains taxes that could have been avoided.

Note also that the federal estate tax now has such a high floor, that very few families will be subject to it, but some states have much lower floors.

Special situations
There's also something that's often thought of as a quirky half-step-up in basis that can apply to certain situations: When assets are owned by joint tenants with rights of survivorship between spouses and one spouse passes away, a partial increase in basis may apply.

So let's say that stock owned jointly with rights of survivorship was originally purchased for $50,000 and is worth $100,000 on the date one spouse passes away. The new basis for the surviving spouse would be equal to the fair market value on the date of death plus the original basis divided by two, or $100,000 + 50,000 / 2 = $75,000. In this way, half of the assets receive a stepped-up basis, which is not too bad.

Using a step-up in basis can lead to big tax savings, but there are limitations to consider. It doesn't apply to assets held jointly with children. Also, you can't use it for tax-deferred accounts such as IRAs or 401(k)s.

Optimizing an estate plan to minimize inheritance, estate and capital gains taxes is no easy task. Complexities in the tax code certainly don't make it easy for the average person to address these issues. Your situation is unique, and that's why you may want to consider speaking to your legal, tax and financial advisors to determine the most appropriate planning approach for you. Speak with a professional before making a major decision.

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